Chapter 2: Externalities - internalisation...Sustainability and the transition challenge Part II:...

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PRINCIPLES OF SUSTAINABLE FINANCE

Chapter 2: Externalities - internalisation

Principles of Sustainable Finance © Schoenmaker and Schramade 2019 Oxford University Press

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Part I: What is sustainability and why does it matter? 1.  Sustainability and the transition

challenge Part II: Sustainability’s challenges to corporates 2.  Externalities - internalisation 3.  Governance and behaviour 4.  Coalitions for sustainable finance 5.  Strategy and intangibles –

changing business models 6.  Integrated reporting - metrics and

data

Part III: Financing sustainability 7.  Investing for long-term value creation 8.  Equity – investing with an ownership

stake 9.  Bonds – investing without voting

power 10.  Banks – new forms of lending 11.  Insurance – managing long-term risk Part IV: Epilogue 12.  Transition management and

integrated thinking

Overview of the book


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}  explain the concepts of externality and internalisation

}  understand the role of government regulation and taxation

}  understand the integrated value approach for measuring externalities

}  explain policy and technology uncertainty

}  use scenario analysis

Learning objectives – chapter 2


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Impact of people on nature


I = P * A * T

I = Impact on natural resources

P = Population (number of persons)

A = Affluence (consumption per person)

T = Technology (impact per unit consumption)

}  Non-renewable or abiotic resources Na are finite

}  Speed of depletion T in years depends on annual demand Da

Ø  T = Na / Da

}  Example: T = 70 years for copper (Cu)

Ø  But depends on new discoveries (Na é)

Ø  And intensified use (Da é) and re-cycling (Da ê)

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Natural resources are finite


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Recycling rates


}  Goal of decent work and inclusive economic growth (SDG 8)

Ø  Preserve social (S) and human (H) in production process

}  Common language: link SDGs to capitals (S, H, N)

}  Not only negative, but also positive externalities

Ø  N: companies investing in renewable energy; material savings

Ø  S + H: companies training employees; sustainable food production and

improvement of health care

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Social and human capitals


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Linking SDGs and Capitals

Sustainable development: I = F + S + E

Ecologist: need to operate within ecological limits

Human rights advocate: ensuring every person’s claim to life’s essentials

Economist: a public good which is not priced

F S E

Perspectives on externalities


Problem: externalities not reflected in market prices

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Internalisation

Government: regulation or

taxation

Civil society: NGOs can

raise awareness (advocacy)

Financials: incorporate

ESG factors in investment +

lending

Corporates: incorporate

costs of externalities in production

Consumers: buy

sustainable products and

services

Internalising externalities


Who should act?


Anticipation of regulation / taxation (e.g. carbon tax)

Reputation – pressure from NGOs and consumers

Future-proof: transition to SDGs by 2030

Why integrate ESG factors?


Ø  Violating SDG 8 - Decent work, incl. paying ‘living wage’

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Example of reputation risk


Internalisation of social and environmental impacts

Business Society

Impacts

Dependencies

Internalisation rate


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The climate economy guru - Nicolas Stern (2015): •  “Why Are We Waiting? The Logic, Urgency, and Promise of Tackling Climate

Change”

Main recommendations

•  Energy infrastructure investments lock in energy use for 20 years è stop

investing in fossil fuel powered utilities and networks

•  First best: carbon tax of $40-50 per tCO2e by 2020 and $50-100 by 2030

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Government intervention


They give theoretically the same result unless the demand curve is uncertain

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Raising prices through taxation to reduce demand

Limiting quantity directly through regulatory quotas (letting prices adjust)

Basic approaches to reduce externalities


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Example regulatory approach


}  Carbon tax is efficient way to get public good of low carbon economy

Ø  Marginal adjustment cost = tax

}  Alternative is Emissions Trading Systems (ETS) – cap emissions and trade

allowances

}  Also taxes on natural resources to prevent depletion

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Taxing externalities


§  Scandinavian countries started in 1990s –

now at $50-130 per tCO2e

§  Result: reduction in emissions, without loss

of economic growth

§  Key is redirecting taxes: taxing carbon

instead of labour

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Early adopters

Laggards §  Most countries have no effective carbon taxes

§  Even worse: fossils fuels are subsidised up to

$330 bn

§  Subsidies very inefficient way of income

support in low-income countries

Carbon taxes in practice


Instruments

•  Living wage (SDG 8) instrumental for other SDGs (poverty, hunger, health care, education), as living wage allows families to live decently

•  Taxes to change behaviour: alcohol, tobacco, sugar rich beverages, etc.

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Low

inco

me

coun

trie

s

Hig

h in

com

e co

untri

es - max working

hours - health and safety regulation - gender equality - minimum wage

- advances in education, but… - underpayment - child labour - human rights

Social externalities

Who should act first to internalise externalities?

•  Government should tax and regulate versus all parties should act

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Discussion: who acts first?


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•  Measuring and monetisation is possible through technology (IT, data) and science (life cycle analyses, environmental economics)

•  Pricing is possible by optimising across F, S and E dimension

What can business do with remaining externalities?

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How to deal with externalities?

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From financial value to integrated value

}  Conventional price € 0.70 (F) and true price € 0.92 (F+S+E)

}  Optimised true price € 0.74

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Optimise production process (reducing S + E)

§  Transport by ship to reduce carbon emissions

§  Solar powered greenhouse

§  Closed-loop hydroponics to reduce water +

fertiliser use

§  Training in health and safety to improve

workers’ skills

§  Gender committees to reduce harassment +

gender discrimination

§  Pay a basic living wage to improve wellbeing of

workers

True prices of roses from Kenya


•  Calculation done on efficiency grounds Ø  But also need to invest in adaptive capacity to absorb shocks

Ø  Example: overinvest in safety to protect people & environment and to reduce production losses

•  Ethical aspects of externalities

Ø  Difficult to monetise ethical aspects, like human rights

Ø  Three capitals (F, S, E) are not substitutable

•  Perverse outcomes Ø  Negative impact of deforestation can be offset by large economic gains

Ø  Use constraint of equation 1.2: SEVt+1 ≥ SEVt

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Pitfalls to monetisation


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•  Timing: when will labour laws be tightened and carbon taxes be introduced •  Reversal: policies may be reversed / changed (e.g. solar panel subsidies)

Policy uncertainty

•  Exponential growth: new innovations and spectacular rise of renewables (solar PV, wind) è Moore’s law: doubling of capacity each x years

•  Changes in consumer behaviour and preferences

Technological uncertainty


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Exponential growth of renewables


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•  Government regulation (e.g. carbon pricing), or •  Technological change (e.g. reduced cost of solar PV or wind)

Stranded assets

•  Carbon pricing affects all carbon-intensive assets •  Intensive agriculture (fertiliser + irrigation) may lead to degraded land (lower

soil quality), species loss and human migration •  Broadly applicable: car parks in cities can become stranded asset (car share)

Which assets?


Environmental exposures beyond energy sector

Agriculture, forestry

and fishing

Mining and quarrying

Manufacturing

Electricity & gas supply

Water supply & waste management

Construction Wholesale and

retail trade

Transportation

Finance

Real estate

0

2

4

6

8

10

12

14

0 200 400 600 800 1000 1200 1400 1600 1800 2000

Emis

sion

s (1

00m

tonn

es o

f CO

2 eq

uiva

lent

)

Value added of each sector (billions of 2015 euros)

Source: Calculations based on Eurostat data. Notes: Real estate emissions include household heating and cooling costs

Environmental exposures beyond energy sector

}  Scenario analysis to get insight in development of externalities over time

}  Strategic approach to making scenarios

1.  Determine most important uncertainties for the future

2.  Elaborate the scenarios with trends, uncertainties and possible actions

3.  Re-present scenarios as appealing stories about (paths to) the future

}  Analyst reports are the fortune tellers of investor community

•  From DCF analysis of main scenario (often ‘business as usual’)

•  Towards DCF analysis of 3 or 4 scenarios including disruptions and internalising externalities

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Scenario analysis


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Impact of scenarios on DCF

Term

inal

val

ue

Cas

h in

C

ash

out

Time

€

Discount Rate Impact on risk premium?

Impact on cashflows? (e.g. loss of market share)

Impact on terminal value?


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Adverse scenario: disorderly transition

•  Shift to low-carbon economy requires strong reductions in carbon emissions

•  An early and gradual shift can facilitate a soft landing in a low carbon economy

•  The adverse scenario is a hard landing with large emissions cuts implemented over a short horizon

•  Amplified by lack of technical progress

•  A later transition may also pose larger physical risks from climate change 0

10

20

30

40

50

60

70

1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

GtCO2peryear

ProjectedpathProjectedpathifemissionsarefixedat2014levelTransitionpathfor2Ctargetifstartsin2020Transitionpathfor2Ctargetifstartsin2025Transitionpathfor2Ctargetifstartsin2030

Physicalrisks

Physicalandtransition

risks

Mostlytransition risks

(b)


}  Central banks and supervisors conduct (climate) stress tests of financial sector using extreme scenarios

}  Goal is to

1.  Raise awareness of major environmental exposures at financials

2.  Monitor major concentrations at financials in supervision

}  Possible instruments

•  Large exposure rules for high carbon concentrations

•  Brown capital charge for high carbon assets

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Stress testing


}  Social and environmental externalities are relevant, but absent in traditional production function and neo-classical finance

}  Instruments to internalise externalities Ø  Government: taxes and regulation first best, but not always done Ø  Business: incorporating S + E in decision making (integrated value)

}  Scenario analysis is tool to deal with uncertainties Ø  Calculate value company under different scenarios

Ø  Prompt companies to reconsider strategy and take action

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Conclusions


Chapter 2: Externalities - internalisation...Sustainability and the transition challenge Part II:...

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